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The Commodities Boom: Is It For Real?

Bubble or boom? That is the question.

Despite all our talk about the benefits of diversification, a lot of people are interested in commodities because of the strong recent returns. Come on, admit it -- even the most focused, balanced investors have noticed the price of oil, copper and gold rising and thought: Shouldn't I have a stake in that?

But now, with prices already sky-high, the question is: Have we peaked? Is the recent run-up in commodities prices an investment-led bubble? Or is Jim Rogers right, and we are on the leading edge of a decade-plus super cycle?

Bubble-istas

The bear argument is led by Morgan Stanley's Stephen Roach, who has called for that sharp drop in commodity prices as the U.S. housing market crumbles and the global economy cools. Roach thinks that slowing growth in China will also dent the demand for industrial materials.

According to Roach, all the excitement about commodities has created a bubble atmosphere, and as more institutional (and even retail) investors get into the commodities game, price movements become exaggerated.

"In the midst of a slightly sub-par upturn in global growth, a low-inflation world is experiencing the sharpest run-up in commodity prices in modern history. If that's not a bubble, I don't know what one is," he wrote.

Of course, he wrote that in May of 2006, and prices have gone nowhere but higher since. Roach is still singing the same tune today, and more and more advisors have noticed bubble-like activity in some parts of the commodities market.

The bulls argue that limited supply matched against voracious demand from India and China will drive prices higher.

Super Cycle

Roach and company run up against some solid arguments from the bull side, though.

The bulls argue essentially that the same forces that led to surging prices in the past remain in place today: namely, limited supply matched against voracious demand from emerging economies like China and India. Famed hedge-fund-investor-turned-commodities-cheerleader Jim Rogers argues that we're in the midst of a "commodity super cycle," which could (and should and probably will) last another decade.

Rogers says that any long-term study of the commodities market will show that it experiences 15-to-20-year rolling cycles betweens bull and bear markets. The reason, according to Rogers, is that bringing new capacity online in the commodities space takes a long time. No one invests in opening new mines or building new lead smelters when prices are low. When prices finally rise, it takes years for new supplies to come to market. In the interim, we see prices surge.

The 1980s and 1990s were bear markets for commodities, according to Rogers, and that led predictably to a big reduction in capacity and an underinvestment in new infrastructure. Now, with the developing world ... developing fast ... we simply can't keep pace.

Rogers boldly predicts that oil will breeze past $150 a barrel as reserves thin, and sees boom times for other commodities as well. His faith in rising commodities prices is supplemented by his belief that we are seeing a long-term shift of global wealth from West to East. Rogers believes that the 21st century is China's to seize, and that China's growing economy will feed demand for millions more refrigerators, washing machines and other goods, all of which will require commodities.

Yes, corrections are round the bend, Rogers says. When "China sneezes, the rest of the world will reach for aspirin," he says in his book, Hot Commodities: How Anyone Can Invest Profitably in the World's Best Market. And he's recently called China a "prospective bubble."

But for the next half-generation, at least, such bumps will represent opportunities to the clever investor.

Neither/Nor

What of a middle ground somewhere between a bearish Roach and the ebullient Rogers?

These middle-road believers think that certain commodities will enjoy a sustained plateau, but others will likely stay weak. Oil at $100 a barrel is already a thing of the past and there's no clear cap, but prices for copper, steel and aluminum have topped out. The fastest growth is behind us.

China's growth is unrelenting, but a significantly greater share of its oil and industrial metals are invested in goods manufactured for export, not domestic consumption. China's economy will remain a key global factor, but it will decelerate. Most Chinese will remain impoverished, with little purchasing power.

One thing is for certain: More investors are coming into the market. The retail end of the commodities industry has boomed, and even institutional investors are upping their exposure to the space. CalPERS recently made its first investment in the commodities space, and is building that into a full position in the coming months.

Bubble or super cycle, investors are deciding that they want to be there to see.

Next Up: Understanding Inflation

Inflation and commodities are always connected, but what that means for your portfolio depends on your perspective.